In his latest Naked With Cash update, participant JW discussed his student loans. Due to his income, which happens to be at a low level, the amount he owes each month to pay back his education loan is zero. How is this possible? He enrolled in a feature for low-income households with certain types of federal loans: the income-based repayment plan.
In general, paying off student loans within ten years is a good target. Earlier is better, of course, but sometimes it just doesn’t seem possible. I won’t suggest what others often provide as “advice:” Don’t borrow so much to pay for college, particularly if your target career is not a highly lucrative one. If you’re having trouble paying down your loan, you can’t go back and change how much you borrowed. You can only move forward. That suggestion offers no real help.
Rather than paying off the full loan within ten years, an income-based repayment plan can stretch the life of the loan up to twenty-five years total, lowering your monthly payment. As your income grows over the years following your graduation, your minimum payments will also grow, so as you are able to pay more (purely from an income perspective), you will shorten the life of the loan.
These plans will generally come with a cost. While there are limitations on how interest is added to your balance (capitalized) under income-based repayment plans, you’ll likely end up paying more interest over a longer period of time. If you extend your loan, it keep your credit score lower for that same period of time, affecting interest rates. For example, you might not qualify for the best interest rate on a mortgage if you are trying to buy a house while still paying off your student loan debt. That’s true even if you’re no longer on the income-based repayment plan.
Once you’ve weighed the advantages and disadvantages — and the advantage might simply be avoiding default on your student loans — there are several different types of income-based repayment plans to choose from.
Pay As You Earn Plan: Introduced by President Obama
The Pay As You Earn Plan is new this year. To qualify, you must have no loans originating before October 1, 2007 and you must have received at least one disbursement after October 1, 2011. The loan types covered are subsidized and unsubsidized Federal Stafford Loans, Direct subsidized and unsubsidized loans, Federal PLUS Loans for graduate students, and some Federal Consolidation Loans. By qualifying for the Pay As You Earn Program, your monthly payment will be reduced to 10 percent of your discretionary income.
Your discretionary income is considered your income minus the the poverty guidelines for your family size. For a household of two people in 2013 living in any state other than Alaska and Hawaii, the poverty level is $15,510. With a household income of $20,000, the discretionary income is $4,490, limiting a monthly bill to $449. As you can see, even under an income-based repayment plan, the monthly cost of the loan could be high.
If the amount you need to pay each month under Pay As You Earn doesn’t cover your entire interest earned that month, the government will pay that accrued interested if it is within a subsidized student loan. Your interest will not be capitalized (added to the balance of your loan so you would owe further interest on that interest) while you have a partial financial hardship and qualify for the repayment plan.
After 20 years, if you still qualify for Pay As You Earn, the government will forgive the remaining balance of your loan. That means you no longer have to make payments, but there is a significant disadvantage to loan forgiveness: any amount forgiven will be added to your taxable income. So while you’ll no longer need to pay your student loans, you’ll have to come up with the money to pay the tax bill.
And rather than having a smaller monthly bill, the IRS will be looking for its tax payment right away.
And at that point you may need to begin applying for an installment plan for your new IRS tax debt. Loan forgiveness isn’t always a great benefit.
Income-Based Repayment Plan: More borrowers qualify
The Pay As You Earn plan is only one type of income-based repayment plans. Although I call all of these options income-based repayment plans, there is one plan whose official name is the Income-Based Repayment Plan (IBR). This plan is less restrictive than the Pay As You Earn Plan. More borrowers qualify because more loans qualify. There is no date limitation to the loans that qualify, so those with student loans originating prior to 2007 can apply for this type of plan.
Under IBR, the most you would need to pay each month is 15% of your discretionary income.
Income-Contingent Repayment Plan and Income-Sensitive Repayment Plan
The Income-Contingent Repayment Plan (ICR) is available for borrowers who do not qualify for either of the above repayment plans. Monthly payments under ICR last a maximum of 25 years before the loan is forgiven, are based on your adjusted gross income and family size, up to the lesser of 20 percent of your discretionary income or “the amount you would pay if you repaid your loan in 12 years multiplied by an income percentage factor that changes with your annual income.”
This loan type has an income capitalization benefit like the others, but it doesn’t kick in until your capitalized loan balance is 10% higher than your original balance.
The final repayment plan is the Income-Sensitive Repayment Plan (ISR). This is available to borrowers who have Federal Family Education Loan (FFEL) Program loans. They’re also available for subsidized and unsubsidized Federal Stafford loans. Federal Direct Loans won’t qualify because these plans are only available through the companies that service the loans. The amount you pay each month under ISR is determined by your annual income and change as your income changes.
Cash flow is important. Whether you’re a new graduate dealing with the expenses of living on your own for the first time or five years after graduation finding yourself unemployed and having a difficult time finding a position that isn’t flipping burgers, you need to find a way to survive with what you have. The first step before looking into these benefits is reducing your expenses to the minimum.
“Living like a college student” isn’t just for dorm life, it’s a good approach to living while you still have student loan debt. But applying and qualifying for an income-based repayment plan may improve your cash flow so that you don’t need to default on your loans while still finding extra each month to invest in your retirement. Being able to save for retirement as soon as possible is important because you can never get that time, and the financial benefit of the growth of your money, back once it’s gone.
Visit the government’s loan repayment website to calculate your monthly payments under one of these repayment plans. It should be the first step you take when you conclude that you cannot afford your monthly student loan bill.
Updated June 24, 2016 and originally published July 5, 2013.